Free Trade- Free trade is a type of trade policy that allows traders to act and transact without interference from government. According to the law of comparative advantage the policy permits trading partners mutual gains from trade of goods and services.
Benefits of Free Trade.
1. The theory of comparative advantage.
This explains that by specialising in goods where countries have a lower opportunity cost, there can be an increase in economic welfare for all countries. 2. Reducing Tariff barriers leads to trade creation
Trade creation occurs when consumption switches from high cost producers to low cost producers
free trade
The removal of tariffs leads to lower prices for consumers and an increase in consumer surplus of areas 1 + 2 + 3 + 4
Imports will increase from Q3-Q2 to Q4-Q1
The govt will lose tax revenue of area 3
Domestic firms producing this good will sell less and lose producer surplus equal to area 1
However overall there will be an increase in economic welfare of 2+4 (1+2+3+4 - (1+3)
The magnitude of this increase depends upon the elasticity of supply and demand. If demand elastic consumers will have a big increase in welfare
3. Increased Exports.
As well as benefits for consumers importing goods, firms exporting goods where the UK has a comparative advantage will also see a big improvement in economic welfare. Lower tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic growth. 4. Economies of Scale:
If countries can specialize in certain goods they can benefit from economies of scale and lower average costs, this is especially true in industries with high fixed costs or that require high levels of investment. The benefits of economies of scale will ultimately lead to lower prices for consumers. 5. Increased Competition.
With more trade domestic firms will face more competition from abroad therefore there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices. 6. Trade is an engine of growth.
World trade has increased by an average of 7% since the 1945, causing this to be one of the big contributors to economic growth. 7. Make use of surplus raw materials
Middle Eastern counties such as Qatar are very rich in reserves of oil but without trade there would be not much benefit in having so much oil. Japan on the other hand has very few raw material without trade it would be very poor. 8. Tariffs may encourage inefficiency
If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs.
Problems of Free Trade for Developing Countries
1. Infant Industry Argument.
If developing countries wish to develop new manufacturing industries they may struggle to compete on an international scale. Therefore, in the short run at least, they may need tariff protection to enable their industries to develop. After a few years they may be able to reduce these tariffs. Many developed countries used tariff protection in the past, especially the Asian "Tiger Economies"
In this regard, it is said free trade usually benefits developed countries more than developing countries.
2. May Prevent Diversification
The lewis model of development suggests that development needs economies to switch from agricultural sector to industrial sector. This is because the marginal cost of production in agriculture is nearly zero. Therefore, moving to industrial production will be relatively costless. However, to diversify an economy protection may be needed. Otherwise developing economies will be stuck with the production of primary products. This makes the economy vulnerable to fluctuations in prices; there is also a low income elasticity of demand for products
3. Environmental Damage.
Free trade and the force of globalisation may lead to exploitation of natural resources.
Benefits of Free Trade.
1. The theory of comparative advantage.This explains that by specialising in goods where countries have a lower opportunity cost, there can be an increase in economic welfare for all countries.
2. Reducing Tariff barriers leads to trade creation
Trade creation occurs when consumption switches from high cost producers to low cost producers
- The removal of tariffs leads to lower prices for consumers and an increase in consumer surplus of areas 1 + 2 + 3 + 4
- Imports will increase from Q3-Q2 to Q4-Q1
- The govt will lose tax revenue of area 3
- Domestic firms producing this good will sell less and lose producer surplus equal to area 1
- However overall there will be an increase in economic welfare of 2+4 (1+2+3+4 - (1+3)
- The magnitude of this increase depends upon the elasticity of supply and demand. If demand elastic consumers will have a big increase in welfare
3. Increased Exports.As well as benefits for consumers importing goods, firms exporting goods where the UK has a comparative advantage will also see a big improvement in economic welfare. Lower tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic growth.
4. Economies of Scale:
If countries can specialize in certain goods they can benefit from economies of scale and lower average costs, this is especially true in industries with high fixed costs or that require high levels of investment. The benefits of economies of scale will ultimately lead to lower prices for consumers.
5. Increased Competition.
With more trade domestic firms will face more competition from abroad therefore there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices.
6. Trade is an engine of growth.
World trade has increased by an average of 7% since the 1945, causing this to be one of the big contributors to economic growth.
7. Make use of surplus raw materials
Middle Eastern counties such as Qatar are very rich in reserves of oil but without trade there would be not much benefit in having so much oil. Japan on the other hand has very few raw material without trade it would be very poor.
8. Tariffs may encourage inefficiency
If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs.
Problems of Free Trade for Developing Countries
1. Infant Industry Argument.
If developing countries wish to develop new manufacturing industries they may struggle to compete on an international scale. Therefore, in the short run at least, they may need tariff protection to enable their industries to develop. After a few years they may be able to reduce these tariffs. Many developed countries used tariff protection in the past, especially the Asian "Tiger Economies"
In this regard, it is said free trade usually benefits developed countries more than developing countries.
2. May Prevent Diversification
The lewis model of development suggests that development needs economies to switch from agricultural sector to industrial sector. This is because the marginal cost of production in agriculture is nearly zero. Therefore, moving to industrial production will be relatively costless. However, to diversify an economy protection may be needed. Otherwise developing economies will be stuck with the production of primary products. This makes the economy vulnerable to fluctuations in prices; there is also a low income elasticity of demand for products
3. Environmental Damage.
Free trade and the force of globalisation may lead to exploitation of natural resources.